Investing lessons from “The Big Short”

 The film came out in 2015 and is based on the 2010 book by renowned author Michael Lewis, The Big Short: Inside the Doomsday Machine. Both the movie and book depict the real-life experience of a few groups of investors who foresaw the 2008-09 US housing and financial crisis and profited from it.

The Big Short was not the first film adaptation of a successful non-fiction book covering the financial crisis. In 2011, HBO adapted Andrew Ross Sorkin’s crisis tell-all Too Big To Fail, which also had a star-studded cast. That story centered more on the few weeks leading up to the collapse of Lehman Brothers and the government's decision to bail out the nation’s largest banks and companies.

The Big Short, however, is a character-driven piece that focuses not just on the events leading up to the subprime mortgage meltdown, but also the conflicted feelings of several men (either real or based on real people) who foresaw the crisis well in advance.

The year is 2005, and Burry begins to suspect the booming U.S. housing market is virtually an asset bubble inflated by high-risk loans. Burry creates a new sort of financial instrument, called a credit default swap, which would allow him to short the housing market—that is, sell positions, on the assumption that housing prices will drop.

Meanwhile, Deutsche Bank executive Jared Vennett (Ryan Gosling) inadvertently discovers Burry’s credit default swap creation, and—agreeing with Burry's analysis of the market—decides to start selling them. One of his clients is hedge fund manager Mark Baum (Steve Carrell). Baum recognizes that poorly structured, high-risk packages of loan securities known as collateralized debt obligations (CDOs) have received AAA ratings from credit rating agencies—implying a degree of safety they don't deserve—and are furthermore being repackaged and resold in highly questionable ways. It's financial institutions' appetite for these securities that is fueling much of real estate's rise—out of all proportion to the industry's fundamentals. Baum was based on real-life hedge fund manager Steve Eisman. Vennett was based on Greg Lippmann, a former bond salesman at Deutsche Bank.

A third plot strand follows two young investors—Charlie Geller (John Magaro) and Jamie Shipley (Finn Wittrock)—who discover a paper written by Vennett about credit default swaps. They seek the investment advice of retired banker Ben Rickert (Brad Pitt). Shipley and Geller make a series of successful bets against mortgage-backed securities and the housing market when it finally does start to collapse, making a fortune on their trades. Geller was based on Cornwell Capital founder Charlie Ledley, while Jamie Shipley was based on Cornwell partner Jamie Mai; Rickert was based on Ben Hockett, a former trader at Deutsche Bank.

Lessons From "The Big Short

Lesson one: Shorting the market is riskier than The Big Short makes it seem

Famed economist Robert Shiller saw the housing bubble growing in 2005. He told The New York Times in August of that year that prices could fall 40%. Also in 2005, The Economist called the housing boom the "biggest bubble in history." Had the heroes of The Big Short made their short bets on the market in 2005 when these sources started sounding the warning bell, their positions would have been bankrupted as the market continued to charge higher in 2006 and 2007. The thesis would have been correct -- the housing market was in full on bubble mode -- but their timing would have been off and their bets would have lost all their value.

Going short is a bet that can run out of time. Even with a simple options strategy, your options will eventually expire. Sticking with a long term, value-based approach eliminates that problem. A quality company will generate profits, dividends, and market returns over the long term, without ever expiring.

Lesson two: Don't blindly follow "the professionals" without doing your own homework

If you asked a manager on the mortgage desk of a Wall Street company in 2004 or 2006 if the housing market was in a bubble, he or she probably would have told you that your question was ridiculous.

How could they have missed such a massive problem sitting right under their noses? They'd see the low credit scores, poor cash flow numbers, and no-down-payment mortgages coming across their desk every day. The researchers point to the incentive systems that paid these managers' salary. Their optimism and exuberance overwhelmed their ability to see the forest for the trees. New York Fed economist Andreas Fuster quoted novelist Upton Sinclair to explain this humanistic problem:

"It is difficult to get a man to understand something, when his salary depends on his not understanding it."

Be wary of how investment advisors earn their own salary and where their incentives may be conflicted with yours or with their ability to see the market for what it is. At the end of the day, it's your money. Make sure you do your own homework.